Changing demographics throws traditional asset allocation a curveball

06 Nov 2015

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Changing demographics throws traditional asset allocation a curveball

Guillermo Roditi Dominguez, portfolio manager at New River Investments and author of related works on the interplay between demographics and real wages, indicated that he had been increasing his holdings of Treasury inflation-protected securities and breakevens in anticipation of the lack of diversification benefits that government bonds are poised to provide.

"If you look at TIPS yields and nominal yields, you see two different pictures: One is trending down still and one is breaking out," he said.

The discrepancy between the two can be primarily attributed to the disinflationary effects of lower oil and cheaper imports, according to Dominguez.

"With yields clearly in an uptrend, I would say the bond market could see yields rise significantly on a change in inflation expectations," he added. "More generally, the market hasn't really had to deal with truly rising inflation expectations in decades."

Nangle also suggested a more fundamental shift in the approach to portfolio construction would be warranted given the scale of the demographic changes.

Many funds have mandates to have a certain degree of exposure to certain asset classes—for instance, 40 percent to U.S. stocks, 20 percent to international equities, and 40 percent to sovereign debt. This traditional method of portfolio construction, according to Nangle, affords portfolio managers limited flexibility to switch between asset classes.

By contrast, dynamic asset allocation consists of taking the fund's mandate—for example, to generate a real return of 4 percent with less volatility than a given benchmark—and grants a portfolio manager more discretion in selecting asset classes to achieve this goal. Nangle noted that one of the funds he manages had no holdings of European high-yield bonds at the end of last year, but now it has a 10 percent weighting, "because it just looks like a nice big risk premium that's opening up that's there for new money to take advantage of."

But for the interest rate backdrop investors have to deal with—and in turn, the asset allocation process—cyclical factors are likely to play the dominant role in the near term.

"I do think the rolling deleveraging the world is going through should keep a lid on global inflation for a while as well," said Mark Dow, founder of Dow Global Advisors. "I expect both those looking for wage inflation and those looking for [the fourth round of quantitative easing or deflation] will end up disappointed."

Nangle's thesis "is, however, a valid concept to file away, so that if you do see signs of it, you might recognize it earlier on," he added.